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CA Intermediate · Financial Management and Strategic Management · Financing Decisions - Leverages

Which statement about financial leverage is correct?

Financial leverage is favourable when the return on investment exceeds the cost of fixed-charge funds such as debt. In that case the surplus return accrues to equity shareholders and raises EPS. It arises from financing, not from fixed operating costs.

  1. AIt arises from fixed operating costs and measures business risk
  2. BIt is favourable when the return on investment exceeds the cost of fixed-charge fundsCorrect
  3. CIt is nil whenever a firm has any fixed operating costs
  4. DIt measures the effect of a change in sales on EBIT

Explanation

Financial leverage arises from fixed-charge funds such as debt and preference capital. It is favourable (positive) when the return earned on assets exceeds the cost of those funds, so EPS rises. The other options describe operating leverage or are incorrect.

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